When your adviser hates index funds

Derek decided it was time to talk with his adviser. He’d been reading about index investing using ETFs for a few months, and he was starting to question whether he was getting his money’s worth out of his pricey mutual funds. But Derek wasn’t prepared for the pushback. “My adviser gets very defensive when I speak to him about ETFs and other options.” The last time Derek brought it up, his adviser emailed him a list of reasons why indexing is an inferior strategy. “Now he has me second-guessing myself.”

These days, advisers who sell actively managed mutual funds are being peppered with questions from an investing public that is finally waking up to the fact that they’re often being poorly served. Here are the most common objections you’re likely to hear from advisers if you ask about index funds, and some suggestions for how to respond.

“Index funds offer no chance of beating the market.”

This is true. Index funds are designed to track their benchmarks closely, but they aren’t free, so they almost always lag slightly. The point is that actively managed funds usually underperform by even more. Well-run index funds routinely finish in the top quartile over any period longer than a few years, meaning they beat at least 75% of their peers.

Actively managed mutual funds do offer the possibility of outperformance. The question is, what is the probability? According to Standard & Poor’s, less than 20% of Canadian equity funds outperformed the S&P/TSX Composite Index in 2010. Over longer periods, that percentage drops even lower. During the last five years, just 2.5% beat the market. Over 25 years, the odds your portfolio will outperform resemble your nine-year-old’s chances of playing in the NHL.

“Average fund performance may be mediocre. But we select only the best managers.”

It’s amazing that there are billions of dollars invested in poorly performing mutual funds in Canada, but no adviser ever admits to recommending them. They all live in Garrison Keillor’s Lake Wobegon, “where all the children are above average.”

Advisers love to build portfolios with five-star funds and tell their clients they own the best in the business. The question is, did they start recommending those funds before they posted excellent results? If your adviser tells you that your fund has beat its benchmark over the last 10 years, ask him whether he was recommending it in 2002.

The best managers can only be identified in hindsight. Advisers can sell past performance, but unfortunately their clients can’t buy it.

“You need a manager who can act defensively to protect you.”

During turbulent markets, active managers can move to cash or concentrate on low-volatility sectors to protect investors from losses. In the second half of 2008, for example, a majority of actively managed Canadian equity funds beat the index. Many managers who played defence in 2011 have also outperformed so far.

Unfortunately, this strategy is a double-edged sword: defensive managers are often sitting on the sidelines when the markets rebound. While most Canadian stock funds beat the indexes in late 2008, more than 70% lagged in 2009, when the market rebounded, and many more missed the surprising upturn in late 2010. Any manager who was out of the market this October missed the best month for stock returns in 20 years.

Over the long term, managers who try to switch between defence and offence usually do worse than those who stayed fully invested all the time.

“You get what you pay for. Many funds with high fees have delivered strong performance.”

Good financial advice is worth paying for. You’ll likely get excellent value from a fee-based adviser who creates a financial plan and who helps you focus on the long-term. But the idea that high fund fees indicate better management is nonsense.

On the contrary, the single best predictor of good performance is low cost. Even Morningstar, a company whose bread and butter is rating mutual funds, acknowledged this in a study published last year: “If there’s anything in the whole world of mutual funds that you can take to the bank, it’s that expense ratios help you make a better decision. In every single time period and data point tested, low-cost funds beat high-cost funds.”

Equity funds with high fees face a big hurdle: the manager may have to beat the benchmark by 3% before costs to add value. As for bond funds, managers have almost no opportunity to outperform if they’re encumbered with a fee of even 0.5%.

You get what you pay for when you buy a washing machine. But as Vanguard’s John Bogle likes to say, in investing you get what you don’t pay for.

“You’re not paying me to beat the market, so I don’t even try. My job is to help you achieve your financial goals.”

I just threw this one in to see if you were paying attention. If your adviser ever says something like this, congratulations. You’re working with a true professional who understands where he or she can add value.